An organization’s budget dictates how it leverages capital to work toward goals. For this reason, the ability to prepare a budget is one of the most crucial skills for any business leader—whether a current or aspiring entrepreneur, executive, functional lead, or manager.
Before preparing your first organizational budget, it’s important to understand what goes into a budget and the key steps involved in creating one.
What Is a Budget?
A budget is a document businesses use to track income and expenses in a detailed enough way to make operational decisions.
Budgets are typically forward-looking in nature. Income is based on projections and estimates for the periods they cover, as are expenses. For this reason, organizations often create both short- (monthly or quarterly) and long-term (annual) budgets, where the short-term budget is regularly adjusted to ensure the long-term budget stays on track.
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Most organizations also prepare what’s known as an “actual budget” or “actual report” to compare estimates against reality following the period covered by the budget. This allows an organization to understand where it went wrong in the budgeting process and adjust estimates moving forward.
Budget vs. Cash Flow Statement
If the definition above sounds similar to a cash flow statement, you’re right: Your organization’s budget and cash flow statement are similar in that they both monitor the flow of money into and out of your business. Yet, they differ in key ways.
First, a budget typically offers more granular details about how money is spent than a cash flow statement does. This provides greater context for making tactical business decisions, such as considering where to trim business expenses.
Related: The Beginner’s Guide to Reading & Understanding Financial Statements
Second, a budget is, quite literally, a tool used to direct work done within an organization. The cash flow statement plays a different role by offering a higher-level overview of how money moves into, throughout, and out of an organization.
Instead of thinking of the two documents as competing, view them as complementary, with each playing a role in driving your business’s performance.
Steps to Prepare a Budget for Your Organization
The steps below can be followed whether creating a budget for a project, initiative, department, or entire organization.
1. Understand Your Organization’s Goals
Before you compile your budget, it’s important to have a firm understanding of the goals your organization is working toward in the period covered by it. By understanding those goals, you can prepare a budget that aligns with and facilitates them.
Related: The Advantages of Data-Driven Decision-Making
For example, consider a business that regularly experiences year-over-year revenue growth that’s offset by rising expenses. That organization might benefit from focusing efforts on better controlling expenses during the budgeting process.
Alternatively, consider a company launching a new product or service. The company may invest more heavily in the fledgling business line to grow it. With this goal, the company may need to trim expenses or growth initiatives elsewhere in its budget.
2. Estimate Your Income for the Period Covered by the Budget
To allocate funds for business expenses, you first need to determine your income and cash flow for the period to the best of your ability.
Depending on the nature of your organization, this can be a simple or complicated process. For example, a business that sells products or services to known clients locked in with contracts will likely have an easier time estimating income than a business that depends on active sales activity. In the second case, it would be important to reference historical sales and marketing data to understand whether the market is changing in a way that might cause you to miss or exceed historical trends.
Related: How to Read & Understand an Income Statement
Beyond income from sales activity, you should include other income sources, such as returns on investments, asset sales, and bond or share offerings.
3. Identify Your Expenses
Once you understand your projected income for the period, you need to estimate your expenses. This process involves three main categories: fixed costs, variable expenses, and one-time expenses.
Fixed costs are any expenses that remain constant over time and don’t dramatically vary from week to week or month to month. In many cases, those expenses are locked in by some form of contract, making it easy to anticipate and account for them. This category usually includes expenses related to overhead, such as rent payments and utilities. Phone, data, and software subscriptions can also fall into this category, along with debt payments. Any expense that’s regular and expected should be included.
Related: 6 Budgeting Tips for Managers
Variable expenses are those your business incurs, which vary over time depending on several factors, including sales activities. Your shipping and distribution costs, for example, are likely to be higher during a period when you sell more product than one when you sell less product. Likewise, utilities such as water, gas, and electricity will be higher during periods of increased use. This is especially true for businesses that manufacture their own products. Sales commissions, materials costs, and labor costs are other examples of variable expenses.
Both fixed expenses and variable expenses are recurring in nature, making it easy to account for them (even if variable expenses must be projected). One-time expenses, also called “one-time spends,” don’t recur and happen more rarely. Purchasing equipment or facilities, developing a new product or service, hiring a consultant, and handling a security breach are all examples of one-time expenses. Understanding major initiatives—and what it will take to accomplish them—and what you’ve spent in previous years on similar expenses can help account for them in your budget, even if you’re unsure of their exact values.
4. Determine Your Budget Surplus or Deficit
After you’ve accounted for all your income and expenses, you can apply them to your budget. This is where you determine whether you have enough projected income to cover all your expenses.
If you have more than enough income to cover your expenses, you have a budget surplus. Knowing this, you should determine how to use additional funds best. You may, for example, move the money into a rainy day fund you can access should your actual income fall short of projections. Alternatively, you may deploy the funds to grow your business.
On the other hand, if your expenses exceed your income, you have a budget deficit. At this point, you must identify the best path forward to close the gap. Can you bring in additional funds by selling more aggressively? Can you lower your fixed or variable expenses? Would you consider selling bonds or shares of company stock to infuse the business with additional capital?
An Important Financial Statement
The person responsible for generating a budget varies depending on an organization’s nature and its budgetary goals. An entrepreneur or small business owner, for example, is likely to prepare an organizational budget on their own. Meanwhile, a larger organization may rely on a member of the accounting department to generate a budget for the entire business. Individual department heads or functional leads might also be called on to submit budget proposals for their teams.
With this in mind, anyone who aspires to start their own business or move into an organizational leadership position can benefit from learning how to prepare a budget.
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